Germany's Spending Spree Triggers Eurozone Borrowing Fears
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Germany's planned increase in defense and infrastructure spending is creating a ripple effect across the Eurozone, pushing up borrowing costs and raising concerns about the financial health of other member states, the Financial Times reports.
The shift in Germany's fiscal policy, marked by a move away from its historically tight-fisted approach to borrowing, is impacting bond yields and making it more expensive for other countries to tap the debt market.
Ten-year German Bund yields have climbed to near 3%, their highest level since a global bond sell-off in 2023, pushing up borrowing costs for other Eurozone governments. This trend has prompted warnings about the potential strain on the finances of more heavily indebted economies.
"The rise in yields could eclipse fiscal space for an increase in defence spending outside of Germany," said Sören Radde, head of European economic research at hedge fund Point72, to the Financial Times. Radde pointed to France and Italy as particularly vulnerable.
French 10-year bond yields have surpassed 3.6%, their highest point in over a decade, while Italian yields have reached 4%, their peak since last July.
A Point72 simulation, factoring in increased defense spending and higher yields, suggests that without spending cuts or economic growth, Italy's debt-to-GDP ratio could climb to 153% by 2030, and France's to 122%, from current levels of around 140% and 115%, respectively.
However, Radde added that "unstable paths" could be avoided if countries implement spending cuts, raise taxes, or benefit from positive spillover effects from Germany's spending boost.
While spreads, which reflect the additional borrowing costs countries face relative to Germany, have remained relatively stable so far, some fund managers warn that this could change if other Eurozone economies follow Germany's lead in increasing defense spending.
"I think spreads will start to widen also, as there is more stress put on the system," said David Zahn, head of European fixed income at Franklin Templeton, to the Financial Times. He added that countries with high debt-to-GDP ratios and elevated yields will face greater challenges in borrowing.
This potential divergence in borrowing costs could intensify disparities within the Eurozone, as individual countries' financial fundamentals come under greater scrutiny.
"Individual country fundamentals will matter a lot more," said Connor Fitzgerald, a portfolio manager at Wellington Management. He anticipates a "general detachment" among borrowers from one another.
Investors have been anticipating increased bond issuance for some time, as evidenced by Bund yields trading above equivalent euro interest rate swaps for the first time in history.
"One could argue that European government bond yields have been too low for some time, compared to other global bond markets, as a result of the self-imposed fiscal discipline of Germany," explained Gareth Hill, a fund manager at Royal London Asset Management. Germany's shift "goes some way to redressing that balance."
However, some fund managers believe that the increased issuance of German bonds will not necessarily divert demand from other Eurozone countries' debt.
"It's not as if there's a shortage of funding for this," said Simon Dangoor, head of fixed income macro strategies at Goldman Sachs Asset Management. He pointed out that German households have ample savings that could be channeled into financing this spending without negatively impacting demand for other Eurozone bonds. Nevertheless, Dangoor acknowledged that the overall rise in yields could create other risks, potentially leading some countries to "tip themselves into a debt sustainability issue."
Investors also see the potential for increased liquidity in German bonds to bolster efforts by Eurozone policymakers to position the euro as a rival reserve currency to the US dollar.
"You could create a useful Eurozone triple-A reserve asset," Dangoor suggested.